Big move for vol of vol

Staying with the volatility theme, the latest jump in VIX was clearly dwarfed by what we saw in 2008 or even in 2011. However that's not true for the volatility of VIX - the so-called "vol of vol". The CBOE's VVIX Index, "an indicator of the expected volatility of the 30-day forward price of the VIX" (see description), has been comparable to or higher than what we saw during those high stress periods. The possibility of VIX doubling or even tripling ("tail" risk) does not seem outside of the realm of possibilities these days - even from the current elevated levels. And traders are willing to pay a relatively high premium to be able to take advantage of such moves.

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From our sponsor:

What's driving VIX futures spread higher?

The focus is on the FOMC meeting this coming week. Market participants, economists, the public  - all want to know if the "taper" is coming. The Google Trends search frequency for "Fed taper" has spiked in recent weeks.

Google Trends phrase "Fed taper" (search frequency over time)

The reduction in securities purchases is however already priced into the market, with the expectations varying between $10bn and $15bn per month. The markets are prepared and are now looking beyond the FOMC meeting. And things are not looking too certain in the next couple of months. The spread between the November and the October (post FOMC period) VIX futures has risen, pointing to expectations of higher volatility ahead.

Where will the markets begin to focus after the FOMC meeting? The situation in Syria of course still runs the risk of causing market havoc globally. But judging by Israel's sovereign CDS spread, it seems that the probability of a US-led military conflict has receded. Prospects for a diplomatic solution or a status quo situation have improved.

And while crude oil prices remain elevated, a great deal of that premium is not due to Syria any more. Instead it is the reduced output from Libya that is keeping prices relatively high (see NYT story, which demonstrates that getting rid of a ruthless dictator does not necessarily improve stability or prosperity).

So if the Middle East is not expected to flare up, why has the VIX futures spread increased so much? Clearly there are a number of other macro risks, but markets are beginning to pay attention to the upcoming budget fight in Washington. And this one has the potential of becoming quite ugly.

CBSNews: - If Congress doesn't send Mr. Obama a spending bill by Sept. 30, the federal government would partially shut down. Quickly after that, Congress will have to raise the nation's debt limit or risk letting the government default on its loans. As these deadlines approach, Democrats and Republicans remain deadlocked over federal spending levels -- lawmakers either want to restore the spending slashed as part of sequestration, or replace the sequester with "smarter" spending cuts.

What could make the debate particularly contentious is the fact that President Obama's approval ratings have slumped recently. House Republicans are running less political risk - and in fact could gain more support from constituents - if they dig in for a fight against what they perceive as a weakened administration. Remembering a similar situation in late summer of 2011, the uncertainty around possible outcomes of such a confrontation certainly has the potential to roil US markets.

Source: Gallup

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From our sponsor:

A steeper VIX futures curve

One helpful risk indicator worth tracking is the steepness of the VIX futures curve (see description). In particular the spread between the December and the September futures provides a measure of risk premium that should in theory encompass both the Fed action and the budget/debt ceiling fight in Washington. Based on the recent spread movements, the market seems to be mostly just concerned with the Fed right now. Will the curve steepen further once the risk of this potential government shutdown becomes more real?

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From our sponsor:

VIX futures curve steepens again

Early in the year we discussed the steepness of the VIX futures curve as the spread between the 7th VIX futures contract and VIX hit a record. This steepening is taking place again. Investors are shorting 1-2 month equity options in hopes these options will expire worthless. The thinking is that Draghi's latest action should hold the markets stable in the short-term while the US government is unlikely to do anything meaningful on the budget until after the elections. Corporate earnings won't be known for a couple of months. Even the German court decision on ESM is not expected until mid September.

This selling of short-term options brought VIX down to a multi-year low.

VIX futures curve: Blue = Now, Green = 1 month ago (source: Bloomberg)

The longer dated vol however has not moved much. The steepness of the curve is approaching the highs reached earlier this year.

7th VIX futures contract minus VIX

This is telling us that in spite of the drop in VIX, there is no confidence that the recent market stability is sustainable over the longer term.

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A flatter VIX futures curve

A few months back we discussed the record steepness of the VIX futures curve. Equity options traders did not trust the rally in stocks, bidding up the longer dated vol. Of course they happened to be right. In fact the futures curve turned out to be a reasonably good predictor for VIX and the VIX curve.

VIX futures curve now and 3 months ago

The curve is now considerably flatter, with expectations of volatility persisting near current elevated levels for some time.

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Economic surprise index eerily reminiscent of last year

The Citigroup economic surprise index is now clearly in the negative territory in a trend reminiscent of last year's decline.

Citi Economic Surprise Index

BW/Bloomberg: - The Citigroup Economic Surprise Index for the U.S., a gauge of how much reports differ from economists’ estimates in Bloomberg surveys, turned negative on April 25 and fell May 3 to the lowest level since September. Last year, the gauge sank below zero for the first time in five months on May 2, the day when the S&P 500 began a 19 percent drop.

Given the rising concerns out of Europe today, there is a strong possibility we may be looking at sharply higher market volatility. As discussed back in March, the VIX futures curve steepness earlier in the year seemed to be a good predictor of uncertainties in the post-LTRO environment.

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The TVIX short squeeze - welcome to the "safety" of exchange traded derivatives

Retail investors are pressing for stricter derivatives regulation in the financial services industry. Yet many of the same investors engage in derivatives trades that would make even an institutional structured products specialist uncomfortable.

Here is a good example - a product known by its ticker symbol as TVIX. It's issued by VelocityShares and is actually an exchange traded note traded on NYSE Arca. TVIX targets to replicate 2x the VIX futures performance (it's a leveraged note on futures contracts on options implied volatility - a "double" derivative). Here is the description:

VelocityShares Daily 2x VIX Short Term ETN is an exchange-traded note issued in the USA. The Note will provide investors with a cash payment at the scheduled maturity or early redemption based on 2X the performance of the underlying index, the SP 500 VIX Short-Term Futures Index less the Investor Fee.

As VIX came crashing down this year, people thought it may be a good idea to be short vol. It wasn't enough just being short though - they wanted to be 2x long US equity implied vol via TVIX. As more people kept piling in, it became what's known as a "crowded trade". Some people were short the ETN and long the VIX futures against it, trying to arb out the discrepancies between TVIX price and NAV. But before the weekend, someone decided to cover their short. And that's when the ETN began to rally, while VIX futures went lower. This continued into today.

In the last 5 days the VIX futures are down about 3%. According to the description above, TVIX should be down 2x or 6%. Yet TVIX is up over 7%.

TVIX vs VIX futures (Bloomberg)

The short squeeze has pushed the price up so much that TVIX now trades at over 36% above its net asset value.

TVIX premium to NAV

It is now nearly impossible to short TVIX since there are none to borrow - thus limited ability to arbitrage out the dislocation. By lunch time today TVIX is up over 1% for the day, while VIX futures are down 5%. So the next time you feel like shorting some vol, try using futures directly, or stick with SPY options. This is not for the faint-hearted and the fact that it is exchange traded (vs. OTC) doesn't make it a whole lot "safer".

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The slope of VIX futures curve hits record

As discussed earlier, the VIX (implied volatility index) futures curve has become extremely steep.

VIX futures curve 

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In fact the slope of the VIX futures curves has hit a historical record last week. The 7th nearby futures contract (UX7) is now almost 13 vol points higher than spot (VIX). The reason for using the 7th contract is that it takes us just over 6 months out - the 6th nearby contract yields the same result. The chart below shows the difference between the two since 2005. The record low of just below -40 was reached during the 08 crisis when the nearby implied volatility was bid up so much, the curve was at a record inversion (negatively sloping).

UX7 - VIX

Where as in 2008 and in 2011 the highly inverted curve indicated an immediate threat to the markets, the current steepness is implying risks further out in time. The market is not buying the sustainability of the current equity rally and is pricing in risks of a material correction later on. This is consistent with other indicators such as the cyclicals underperformance. The record steepness points to the fact that central banks have been successful in suppressing current volatility, but the market is fully expecting it to show up again a few months down the road.

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