How The End Of QE Roiled The Volatility Markets

The world's most potent central bank, the Federal Reserve, officially halted its third round of Quantitative Easing (QE) on 29 October 2014. Since then, the S&P 500 is some 4.7% higher while the shape of the Treasury yield curve has become radically different, Fed jawboning not withstanding.

The then Fed Chairman, Ben Bernanke, started "tapering" the central bank's $85bn/month in securities purchases in February of 2014, gently kneading the market's dough - signaling the imminent cessation of kool-aid administration that the markets have so loved since debuting in 2009.

No one will ever doubt QE's efficacy in spurring multiple expansion in equities, or its vicarious atonement for the sins of too-big-too-fail financial institutions. However picturesque a picture the Fed's $3.2trn monetary stimulus has painted, the markets have been quick to shift their attention to another seemingly imminent event - a rate "liftoff" some time in 4Q15.

All Seems Well On The Surface

Although the treasury yield curve has changed dramatically in shape, the 5 and 10 Year spectrum of the curve has stood up relatively well even absent the Fed's demand. The 5 and 10 Year has seen their prices rise by 0.623% and 2.08% respectively over 5 months despite the significant increase in the occurrence of bi-directional swings.

Although the treasury yield curve has changed dramatically in shape, the 5 and 10 Year spectrum of the curve has stood up relatively well even absent the Fed's demand. The 5 and 10 Year has seen their prices rise by 0.623% and 2.08% respectively over 5 months despite the significant increase in the occurrence of bi-directional swings.

Most dollar-based markets including equities and treasuries have been in the money for the 5 months that have since elapsed since the passage of Taper. Although the view on the real economy is (constructively) mixed, the general consensus has been one of a strong and robust economy. The American economy is in our minds, the cleanest of the clean shirts; we cannot say the same for the rest of the developed markets exuding Germany, which probably falls in the same league.

On the surface, asset prices seem to have behaved rather well despite the multitude of turbulent episodes which was perhaps the market's way of throwing a tantrum after all that flow from the Fed was cut off. Across the board, most financial markets have risen in price. All that seems even shinier if we factored in the Dollar's epochal triumph over the rest of the world's currencies.

Or is something more sinister brewing, our curious minds wish to know...

Going Underground With Volatility

Looking at the implied volatility across the asset classes, it doesn't take too long to notice an anomaly. Technically, the flares in volatility started a while before QE officially ended. It was talk about the completion of the Fed's tapering operation that rattled the markets. Initially, the volatility surged across all 4 asset classes, treasuries being affected most adversely, followed by equities, then currencies and energy. After the major correction in September, equity volatility normalized quickly while that of interest rates continued to stay elevated. As we approached the December, it became obvious that volatility had been transient in equities, and was gradually being migrated to currencies and energy. Note that there were major trends in FX (Euro, Dollar, Swiss Franc, ect) and the energy space (crude oil, nat gas). In hindsight, the migration in volatility made sense as we saw major price movements in most other asset classes except US equities, which mostly traded sidewards. Chart courtesy of Zero Hedge, illustration ours

Looking at the implied volatility across the asset classes, it doesn't take too long to notice an anomaly.

Technically, the flares in volatility started a while before QE officially ended. It was talk about the completion of the Fed's tapering operation that rattled the markets.

Initially, the volatility surged across all 4 asset classes, treasuries being affected most adversely, followed by equities, then currencies and energy. After the major correction in September, equity volatility normalized quickly while that of interest rates continued to stay elevated.

As we approached the December, it became obvious that volatility had been transient in equities, and was gradually being migrated to currencies and energy. Note that there were major trends in FX (Euro, Dollar, Swiss Franc, ect) and the energy space (crude oil, nat gas).

In hindsight, the migration in volatility made sense as we saw major price movements in most other asset classes except US equities, which mostly traded sidewards.

Chart courtesy of Zero Hedge, illustration ours

We wanted to go deeper underground with our analysis on the effects the end of QE have had and is currently having on US markets. Understanding that the end of QE also brought the imminence of a rate hike into prime question, our analysis therefore covered the dual faces of monetary policy tightening - halting asset purchases, and raising interest rates.

Measures of volatility - realized and implied - are often overlooked factors when strategizing trade ideas. The very definition of risk in of exposure in the financial markets is the variance of returns, or volatility of returns. Although unseen to the naked eye, implied volatility gets priced into the markets in the form of risk premiums. When we look at possible avenues to hedge our positions in our proprietary trading portfolio, the cost of such hedges is often heavily weighed by the volatility premium we pay to establish those hedges.

On the flip side, the presence of volatility in an asset's price creates opportunities for profits and losses. The absence of volatility would mean a stoically dead market; returns would have to be indirectly sought elsewhere. In essence, volatility is the market's lifeblood. Although there is a strong case that maps the correlation between liquidity (volumes) and volatility, we will be discounting the liquidity effect for the purposes of this note.

To gain more insight, we wanted to visualize the term structure of the VIX; something we believe will offer a much more useful perspective.

The most popular measure of volatility is the VIX, an index that quantifies the implied volatility of all S&P 500 index options that trade on the Chicago Board Options Exchange (CBOE). Also called the "fear index" the VIX is the most commonly used benchmark for measuring volatility in the US equity markets. However, looking at the VIX itself or even against equity returns would just reveal the known - that volatility increases when prices fall and moderate as they rise. This is nothing new.

A term structure imposes a snapshot view of where prices of each future contract trade relative to one another. A term structure usually comes in the form of a contango; where spot/near-dated prices trade cheaper than future prices. The inverse would be backwardation; where spot/near-dated prices trade dearer than future prices. For instance, we noted in a previous note that the term structure of crude oil futures were trading at an unusually steep contango, something that we felt implied that prices would either continue falling at a rapid pace of rebound sharply. Prices eventually saw a sharp bounce.

Equity Downside Protection Cost Surge

(Click to enlarge)

How To Read: In this 3-axis chart, time runs along the X Axis; volatility runs up the Y Axis; while each series of VIX futures runs across the Z Axis (spot - 8 months out)

Historical VIX Term Structure: Having slumbered into a period of extremely low implied volatility (where spot VIX trade at a record low of 10.61 in June 2014) in the midst of a tapering Fed, flares in the VIX have gotten indicatively more abrupt and frequent as QE approached its terminal stage. During severe dips in equity prices, front-month VIX futures traded higher than back-month. This is the usual case as hedges are sought for the near term.

The sporadic nature of these flares should be a cause for concern, but this isn't not the key takeaway.

Chief of our findings is the elevated levels the entire VIX structure has been trading on in the immediacy of halting the Fed's QE.

This is evidenced by risk premia of the 3-month and beyond. While spot and 1-month VIX have seen choppy prices on their own, the serenity as we edge up to 3-months and beyond is a crucial observation. On top of this, note that when juxtaposed to the period before September's deep correction in equity prices, it seems medium and far dated volatility has been elevated ever since despite equity prices resuming their ascent.

Chart by Business Of Finance

We consolidated a time series of daily VIX futures prices, which allowed us to create a visualization of how the entire VIX complex has traded over the last 35 months. The model on the right is the result of a rather tedious amount of data manipulation; we had to constantly roll all 7 series of VIX futures as they expire each passing month.

Our findings are nothing short of eye-opening, and correlates well to the fundamentals of monetary easing, or the lack thereoff in the current environment.

The visualization reveals a hidden development which has not been brought to light in financial media, at least not that we know about.

It seems to us that medium to long term protection against downside in equity prices is a theme that has been ongoing since the arguably deep correction in stock prices in September 2014 which saw the VIX term structure turning massively inverted.

The plausible explanations for this observation might be traders who were sellers of volatility premium (put writing) during the period where stock prices were constantly heading north with the entire term structure being incredibly flat, had reversed those positions in 4Q14.

Market participants are not mincing their words as an era of volatility suppression sees its grand closure. For the period 5/22/14 to 3/26/15, the cost of a 55% OTM put option on the S&P 500 index has risen anywhere from 4bps to 25bps annualized. This starkly contrasts to the cost of hedging via equity CDSs, which has hardly changed over the course of almost a year. Our prognosis resonates well with the thesis we put forth: Dramatically diminished put writing (volatility selling) on equities. Although we cannot speculate if the surge in put risk premiums is more a cause of protection buying or the unwinding of shorts, what we can conclude is that the landscape has changed significantly enough for the options markets to exhibit such a phenomenon. Chart courtesy of Goldman

Market participants are not mincing their words as an era of volatility suppression sees its grand closure.

For the period 5/22/14 to 3/26/15, the cost of a 55% OTM put option on the S&P 500 index has risen anywhere from 4bps to 25bps annualized. This starkly contrasts to the cost of hedging via equity CDSs, which has hardly changed over the course of almost a year.

Our prognosis resonates well with the thesis we put forth: Dramatically diminished put writing (volatility selling) on equities. Although we cannot speculate if the surge in put risk premiums is more a cause of protection buying or the unwinding of shorts, what we can conclude is that the landscape has changed significantly enough for the options markets to exhibit such a phenomenon.

Chart courtesy of Goldman

And as further analysis from Goldman Sachs suggests, on top of vanishing put writing, OTM (out of the money) protection has become markedly more expensive since 2H14. In short, the cost to insure against downside in equity prices has sky rocketed. The reason? We are in an environment in which few are willing to assume the risks of writing protection.

Historically, there is a positive correlation between interest rates (money markets) and equity prices. What makes the current episode more treacherous to thread is the withdrawal of the largest source of demand for treasury securities. After years of purchasing treasury securities in the secondary market, the Fed's only means of flow stems from maturing bonds.

While we feel there is no dearth of reasons to be exposed mid to long dated treasuries, the key risk still lies in the Fed's interest rate policy, which in turn is suspended on a delicate string of inflation and inflation expectations.

Market participants certainly understand that the end of QE also meant that markets would become much more unpredictable and inherently more volatile; on the surface and underground.

No Crash, But Lots Of Chop

(Click to enlarge)

How To Read: A value of 1 means spot VIX equals the center-weighted price rest of the term structure. A value under 1 means spot VIX is lower, while a value above 1 means spot VIX is higher. A value under 1 connotes a typical contango, while a value over 1 connotes atypical backwardation (inverted). Generalizing, the higher the value, the greater the demand for immediate equity hedges.

VIX Curve Vs. S&P 500: The VIX term structure usually becomes very flat or even inverted in occasions when the S&P 500 enters into more pronounced correction phases. This was best illustrated when stocks started plunging on 19 September; spot VIX traded almost 25% higher than the rest of the curve at the climax of the sell-off.

The cessation of QE hallmarked more frequent and unpredictable events that were each able to raffle the volatility markets. In terms of the VIX term structure, we are witnessing a flatter curve with larger than usual degrees of backwardation when equity prices experience dips. This might be signaling a more nervous market.

Chart by Business Of Finance

As we stated above, our analysis indicates to us that a major correction (defined as 10% or more price decline) in US equities remains unlikely despite a Fed that is practically sitting on the fence while deciding on the timing of a rate "liftoff".

(Click to enlarge)

How To Read: The top pane plots the S&P 500 index and VIX. The bottom pane plots the 14-day realized correlation between the S&P 500 index and the VIX (black histogram), the 14-day realized volatility of the VIX (red line), and a 50-period exponential moving average of the 14-dat realized VIX volatility (dotted blue line).

Note that realized correlation as seen here does not refer to pairwise correlation coefficient. Realized correlation coefficient values range from 1 to -1, with 0 connoting no correlation, 1 connoting perfect correlation, and -1 connoting perfect inverse correlation. Realized VIX volatility is also referred to as volatility of volatility ("vol of vol"). Vol of vol measures the variance of implied volatility, and is a measure of this 14-day historical volatility of the VIX.

Convexities: We feel it is insightful to look into the convexities of the volatility markets from time to time. Convexities refer to the second order derivatives of an asset's price, the VIX in this case. Due to the non-linear nature of volatility, we can look into how implied volatility has behaved vis-à-vis the various degrees of correlation volatility has to equity prices.

Realized correlation usually surges when the VIX spikes during corrections in equity prices. This is no surprise because as hedges are initiated in the volatility markets in reaction to falling equity prices, that very action bids up the VIX - a self-fulfilling prophesy.

Since July 2014, vol of vol started to rise as the market began to prepare for the termination of QE in October. This is evidenced by the sustained increase in the 50-period moving average of this measure. It is interesting that in addition to higher absolute levels of implied volatility, implied volatility itself has gotten more volatile; the VIX has become more volatile.

Chart by Business Of Finance

The passage of QE has generated major fluxes in the volatility markets as we have spoken about above. These fluxes however do not seem to point to equity prices being perched on a cliff's edge. Rather, they seem to be telling us to expect a continuation of what we have already been experiencing for much of 2015 - lots of chop.

Without straying too far off topic, we should add that most of the markets we cover have become extremely data-dependent ever since the Fed signaled to the markets that they were contemplating a rate hike. The progression of its language in each FOMC meeting, that of which culminated with its latest policy meeting in March, seemed to have directed the market's attention towards US macro economic data more than anything else.  

That being said, the Fed is given little choice but to carefully evaluate the progress of the metrics it uses to weigh the potential risks of raising the Fed funds rate prematurely. The diabolical nature of US macro data over the last 4 months is partly the cause of broad-based volatility we have experienced thus far. On one hand, we feel expectations have been erring too far on optimism that any "negative" print looks relatively weak. On the other hand, there is a real risk that the US economy might have entered a slowdown phase; there is ample evidence to suggest this.

Our analysis points to a sustained period of heightened vol of vol; that is volatility itself being more volatile than historically so. Corrections in stock prices should continue in their sporadic intervals. The internals also look to us to be more fragile than they have been since 2013, and medium to longer term hedging costs seemed to have increased significantly after mid-2014.

We strongly believe that the main reason attributing to this disconcerting juncture has been the offset of massive positions which were essentially indirectly bidding up equity prices through the sale of volatility premiums. The notion that the Fed has been writing puts underneath stocks prices has never been truer to this day. Now that the Fed's most potent backstop to a decline in equity multiples has disappeared, those positions of gargantuan notional had to follow suit.

In the absence of put writing, equity markets and their convexities have morphed into their naturally unpredictable natures. This should not be a surprise to seasoned professionals with skin in the game pre 2008. The virtuous effect QE had on stock prices has been gradually fading, and we feel the possibility of a rate hike in 2015 has terminally ended that moderating effect. It will be interesting to see how the markets will adapt to an era of minimal central bank intervention.