Finding a New Equilibrium for the VIX

by Hubert Marleau, Market Economist, Palos Management

August 9, 2024

Behavioural finance is not a clear science, making it difficult to assess market sentiment precisely. This is why the Chicago Board Options Exchange constructed a volatility index, named VIX, to measure in real time the level of risk and stress in the market and the relative strength of price changes of the S&P 500 over a 30-day horizon. It has become globally known as Wall Street’s “fear gauge”.

The long-run average of the VIX has been around 21. High levels above 28 can point to increased fear and volatility in the market,while low levels when it is below 14 can point to calmness and stability.

Last Monday, it spiked to 65, something it had not done since 2008, breaking its 1-year long lull dramatically and matching history’s worst crisis. It’s as if it lost its bearing. Many talking heads have put the blame entirely on the “yen carry trade.” In my judgement, however, that’s a bit fallacious. The VIX had been creeping up steadily throughout the months of July accelerating furiously in the early days of August, before stabilising around 24.5. In other words, something was going on even before the unwinding of yen-loans to fund investments had begun.

What is important to know here is why this happened in the first place. I think there were 3 main contributors: the broad complacency, which had suppressed the VIX for years, that the economy would continue to defy dire expectations and remain resilient, was slowly losing steam and being tested, which was followed by an unexpectedly weak job report. The element of surprise then jumped in, when worries over a rising unemployment rate dramatically increased the risk that an outright recession might be underway after all, in the face of a stubborn Fed.

Economists at Goldman Sachs, JP Morgan and many other distinguished investment banks suddenly increased overnight the chances of the US being in recession by year-end. The new odds carried weight because families were pushing back on spending. They no longer have a buffer of cash built up during the pandemic, and the personal savings rate is near record lows. As the wealth effect runs out and discretionary savings rise as employment slows, nominal GDP is bound to fall.

While all of this was going on, the Bank of Japan lifted its policy rate to 0.25% on July 31 as the prospect of a U.S. rate cut seemed high, pushing the yen sharply up. In this connection, carry-trade speculators, the most popular funders on Earth with roughly $500 billion outstanding, who were invested aplenty in newly volatile-risky American assets for free, realised out of the blue that the party was over, selling much of what they owned indiscriminately in a thin summer market, exasperatedly pushing theVIX higher to the 65 point, registered Monday last.

Assuming that it was the direction of the VIX that caused the sell-off in equities, turning the “yen carry trade” upside down by erasing profits made on assets paid for with yen loans, which had suddenly got expensive either because the cost of their loans had risen or the exchange rate had risen rising, finding a new equilibrium for the VIX will take some time.

First, the Bank of Japan must stop raising its policy rate. This was done on August 7 at 3.08 a.m., when Shinivhi Uchida, Deputy Governor of the Bank of Japan, announced that the bank would not raise its policy rate when financial and capital markets were unstable because it could affect corporate investment. He stressed the dovish side of the Bank of Japan’s current policy, however, observing that the policy rate of 0.25% was especially low in real terms and adding that the Bank would continue to support the economy by maintaining highly accommodating financial conditions.

Secondly, the Fed must cut interest rates in September to shut-up the cohort of die-hard hard-landing proponents. Bond traders believe that the prospective is a done deal.

Thirdly, a soft landing scenario needs to be a lock. Here, however, there are grounds for optimism. The non-manufacturing ISM index showed that the service sector was back in expansion mode and jobless claims came down to 233,000, suggesting that the economy was in reasonably good shape. Indeed, the Atlanta Fed’s third quarter growth estimate for real GDP growth was updated on August 8 and remained unchanged at 2.9%.

Cutting the Fed’s policy rate while the American economy is slowing but not plunging adds credibility that we shall indeed get a benign soft landing. 3 days later, the VIX, which brought about the dramatic sell-off in stocks, closed at near 28, as relative calm returned to global financial markets. It now looks as if Japan’s carry-trade earthquake is over as the majority of the market metrics are more or less back where they started before the mayhem began. I’m sure the yen position is still short; nonetheless I strongly suspect that a large chunk of the highly sensitive portion has already unwound. Thus much of the damage of the selloff has been repaired and the financial dynamics of the market restored because the expectation that the Bank of Japan will not raise its policy rates further, coupled with the conviction that the Federal Reserve will decrease its policy rate, is viewed as guaranteed. Both Goldman Sachs prime brokerage and Morgan Stanley data showed institutional investors had bought the selloff, knowing that extreme movement is due to lack of liquidity in the option market and under the Leon Tuey 8% rule.

While all of this is fine and dandy, it remains that the mayhem happened. I trust that the central banks will live up to their commitment, if not obligation, to keep the financial markets stable. One should bear in mind this would tend to weaken the dollar, but it would also strengthen commodity prices and emphasise the rotation trade. Financial conditions not only reveal information on the economy, but can also spillover to impact it. By the end of the week, the VIX closed down at 20.37, the DXY down at 103.1 and the S&P 500 up at 5343 and the Bloomberg Commodity Index up at 95.51.

PS 1: Carry Trades in Requiem by Bryce Elder for the FT: “A carry trade is all the financial markets cliches at once. It’s picking coins in front of a steamroller en route by escalator to a crowded rooftop bar before they take away the punch bowl. It’s Wile E. Coyote’s reversion to the mean, gradually then suddenly, having changed his mind after the facts change.”

PS 2: Put simply, currency carry trades are not a buy-and-hold investment. They fall under Stein’s Law - if something can’t go on forever, it won’t. Unfortunately, forecasting precise moments of widespread deleveraging that are not economic ones are impossible.

PS 3: Ed Yardeni blamed the selloff on the Sahm rule: carry trades and too many bulls.

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