The Ratchet Effect in Action and Its Effect on VIX

US markets were closed yesterday for the Memorial Day holiday, but global markets and overnight futures were able to partake in the enthusiasm that followed from another set of hopeful comments about the peace process in the Persian Gulf.  As I write this on Tuesday morning, scant details have emerged, and the negotiations could not have been helped by new US strikes on Iranian targets last night.  Nonetheless, traders remain generally unperturbed.  To them, the setup, not the outcome, seems to matter more.

On Saturday morning, reports emerged that the US and Iran reached a deal to reopen the Strait of Hormuz.  Even though details remained murky, that prospect led to sizeable moves in equity markets and drops in crude oil futures when global markets reopened on Sunday night.  The timing was certainly encouraging, since a disproportionate number of positive reports about peace talks seem to emerge just before markets open for business.  Coming at the start of a long weekend, investors looked upon this as more substantial than usual.  (Skeptics could assert that the timing was aimed to distract politicians and the public from discussing the poorly received $1.776 billion “anti-weaponization” fund over the long weekend, but that is clearly not the prevailing market view.)

As a result, S&P 500 (SPX) mini futures (ES) traded about 1% higher, and July Brent futures (COIL) traded down by more than $8 during yesterday’s session.  Today, after the market had time to digest the news of the US strikes and the lack of fresh reports about progress in the peace process, stocks and Brent had recouped about half of those moves by noon EDT.  Bond traders are also generally pleased with the reports since Treasury yields are about 6 basis points lower throughout much of the curve. 

It remains difficult to tease out the “chicken and egg” nature of the equity market’s enthusiasm for anything involving the Persian Gulf, though. 

Oil market reactions are fairly straightforward.  When there are developments that might ease the bottleneck in the Strait, prices fall; when those fail to materialize or reverse, prices rise.  Bond market reactions are not quite as clear-cut.  They have tended to follow oil prices, at least broadly speaking, but they remain sensitive to other policy considerations like Kevin Warsh’s assumption of the chairmanship and Governor Waller’s apparent change of heart about the Fed’s easing bias. 

Stock markets, however, seem to have a more malleable approach to interpreting geopolitical news.  To be blunt, equity traders are historically far worse at that task than their commodity and fixed income counterparts. The prevailing stock market mindset is relentlessly positive, if not exuberant.  The news flow is incorporated into equity prices with that in mind.  Good news, or even the hint thereof, is a reason to rally; anything short of unmistakably negative news is greeted with a relative yawn.  Hence, the “ratchet effect.”

Expectations for future volatility, as measured by the Cboe Volatility Index (VIX), are quite modest, especially against the backdrop of an inherently unstable global situation.  Bearing in mind that (1) VIX measures market expectations for SPX volatility over the coming 30 days and is not constructed as a “fear gauge”, and (2) because all SPX options with 23-37 days to expiration with non-zero bids are incorporated into the calculation, including far out-of-the-money calls, we can assert that even though VIX is firmly above historic lows in the “tweens”, it still reflects a relatively sanguine approach to future volatility. 

The point about the above-market calls is important.  In recent weeks we have seen skews on SPX and almost all tech-related products (of which SPX is one, given its top-heavy, tech-heavy market cap weighting) get more symmetrical.  Typically, we see below-market puts trade with far higher implied volatilities than above-market calls.  The basic reasons have always been that (1) there is natural demand for hedging “insurance” and a dearth of natural put sellers, while (2) there has always been a natural supply of calls from eager writers.  That balance has not completely flipped, but there are relatively fewer investors demanding downside protection while at the same time call writers are less eager to place offers when stocks head relentlessly higher. 

I’ll add to that a key change in the hedging dynamic: “FOMO Insurance.”  Institutional investors can’t risk being left behind by a monster tech-led rally, but they might not want to allocate new funds after the recent sharp advance.  Instead, they hedge their risk of underperformance by buying upside “protection” via out-of-the-money calls.  That is giving a lift to VIX and somewhat flips the notion of that index’s role as a “fear gauge” on its proverbial head.