We Were Certainly Uncertain

Ronald Reagan used to joke that if Trivial Pursuit were designed by economists, “it would have 100 questions and 3,000 answers.” In a similar vein, acerbic investors often point out that economists have “accurately predicted all 21 of the last 4 recessions.”

Well, everyone from tenured econ professors to armchair economists have been ruminating on last week’s inversion of the U.S. yield curve. On Wednesday, August 14, the yield on 2-year Treasuries (1.63%) exceeded those of the 10-year (1.62%).

In fairness to the economists who signal elevated concern, the Federal Reserve Bank of New York uses a model to forecast the probability of a recession based on an inversion in the yield curve (specifically, the 3-month bills vs. 10-year bonds). The NY Fed’s forecast is running 31.5%, which is the highest level since late 2007.

Inside Volatility Trading 8-20
Source: New York Federal Reserve

Risk transfer was on full display in the middle of last week following fixed income fireworks. The SPX fell 1.4% on the Wednesday (8/14) open, and continued to decline until Thursday (8/15) afternoon. The 8/14 close was the lowest S&P 500 settle since June 5.

Over the same time frame, the VIX Index and related futures jumped to levels last seen in late 2018 and early 2019. The chart below is from Bloomberg and shows a continuous (rolling) front-month VIX future over the past year:

Inside Volatility Trading 8-20 2
Source: New York Federal Reserve

The average since mid-August 2018 for the lead-month VIX future is 16.95. The highest settle over the last 52 weeks was December 19, at 26.20, and the low occurred on April 17 at 11.70. Front-month futures closing above 20 is fairly unusual, with the preponderance of that trade during late 2018 and early 2019. The August 5 (Trump tweet on new tariffs) and August 14 (2-10 inversion) month-1 VIX futures closes are in the 90th percentile for the past year.

Volatility in general can be a function of your perspective and sensitivity to duration. In some respects, the volatility market behaves like the fixed income market. Rates and volatility are bound: There are limits—albeit wide ones—between which they vacillate. Fed policy can directly impact the short end of the bond curve, but they have far less impact further out in time.

Those actively managing risk may view volatility differently than those with a longer time horizon. You could argue that volatility is a source of future returns for the passive investors. More opportunistic types may be impacted positively or negatively by the recent uptick in forward-looking and realized volatility.

Both passive and active market participants have tools at their disposal that can potentially mitigate some of their volatility risk. Futures and options have tremendous flexibility independent of your time horizon.

In the short term, the Fed Minutes from its last meeting will be released on August 21, which precedes its annual symposium in Jackson Hole, Wyoming. The topic this year is “Challenges for Monetary Policy,” of which a recession would almost certainly qualify.

For those that view the glass as more than half full:


VIX Selling VOL 411 8-20

Video: VIX Selling Pressure


RMC Inside Vol Blog
Trader Forum

Cboe Will Be Attending:

August 28, SGX Market Access Charity Night in Singapore

September 3 – 6, International Trader Forum (ITF) in Madrid, Spain

September 17, ALTSSEA in Seattle, WA

September 26, Rosenblatt GELC in New York, NY

For questions or to provide feedback on the newsletter, please email Alexa Auerbach, Director of Product Marketing, at [email protected].

To learn more about the VIX Index, visit www.cboe.com/vix.