Intermarket VIX: a safe ride for risk-on markets, or is it?

One of the bets that we had at the start of this year was to buy the VIX; It was sure to be a wild ride in 2017.

Fundamentally, we are living through Trump's first 100 days and that certainly has given volatility a boost at times. However, the standard gauge of fear in the market, aka, the short-term implied equity volatility (the VIX) had been at 18-month lows at the start of his term.  That could have reflected a sign of stability and confidence in his presidency and a boost for the equity market. Indeed, US stocks rocketed higher post-election, corporate earnings rebounded and global growth was expected to increase. Or, has something else been going on - because it certainly has felt very volatile out there at times even though the VIX has been at historical lows? 

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We have also been anchoring ourselves to the Fed and each and every comment coming from Fed officials let alone the Fed meetings; again, there has been some volatility but the VIX has not been showing us a great deal around those events. Then, just today, the British Government's decision to trigger Article 50 might have given the markets some volatility and a rise int he VIX but ... no, it hasn't! Both the VIX, and Deutsche Bank's CVIX FX volatility index, are back below their 50, 100 and 200-day moving averages as Kit Juckes, an economist at Societe Generale points out.

Juckes notes that the excitement we have seen of late was caused by the failure of President Trump's healthcare bill, but this has been washed away as bond yields stabilise. "A 2.42% 10-year Note yield is neither too hot nor too cold, consistent with a couple more rate hikes this year but not with the Fed's famous dots that take rates to 3% in due course. Rates stay below the nominal growth rate of the economy and asset prices take comfort."

Juckes also explained that both the dampening effect on volatility and the over-correlation of financial markets that Helene Rey blamed on too-low rates in her "Trilemma" are back as the dominant force behind markets. "In FX, that's a recipe for yield-hungry, risk-tolerant investors to take the lead."

However, on further analyses, what we also must be mindful of is how the VIX correlates to the S&P 500. It completely depends on the performance of individual stocks within the index. For example, when all stocks in the index are in a bullish trend or in a bearish trend, the inter-correlation of the index is either high or positive. When we have rogue performances from individual stocks or sectors, as we have seen a lot recently in energy and financials, for example, correlation is said to be low, or negative. So, when all stocks go up 3%, the index goes up 3% and vice-versa. Therefore, price changes in the index may not accurately reflect changes in the underlying companies and hence this may explain the low performance in the VIX even when it feels volatile out there.

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The turbulence that we have seen this year has been more sector related in the index and has not affected the market as a whole to the same extent as previous years in 2015 and 2016 for example. In fact, the ratio of realized volatility at the sector level to the broad index is the highest in 5 years. 

What is more concerning is that the low level of the VIX indicates limited demand for downside protection. While investors continue to ride the tide all the way out, that tide will eventually have to come back in. With the number of concerns over the GOP, the US debt ceiling and possible government shut-down as soon as this June, when they run out of money, the Trump trade could take a serious hit. Risk-on FX maybe shelved very suddenly with some hard landings out there. This could be a positive environment for emerging market currencies such as the ZAR should China continue to perform in a more politically stable and growing South African economy while the dollar takes the brunt of it all.