Sunday, March 27, 2011

The Bernanke Put and Volatility Collapse: A Look at the Vix and 2 Year Swap Spread

The slow melt up in US markets has been nothing short of astonishing. Global unrest that would have resulted in market sell-offs in the past have been shrugged off as non-events. Like a sailing ship depending on favorable winds, market bulls have continued pushing equity indices ever higher despite sighting multiple rocky shoals.

Political unrest in the MENA (Middle East North Africa) region, continuing EU insolvency, and higher commodity prices (particularly in fuel and food costs) have all been sighted and then dismissed as unimportant in the greater scheme of things. The force behind these winds has of course been Ben Bernanke's intervention on the markets, primarily in the Federal Reserve's Quantitative Easing programs (QE 2.0 announced last August) but also the continuing legacy effects in the distressed debt markets and cross currency swap programs w/other nations. The financial press has dubbed this combination of corollaries the "Bernanke Put" after the calming effect the Fed Chairman has imparted on market volatility.

The Bernanke Put's most dramatic effect has also been its most recent. The S&P 500 Vix which is a widely used indicator of volatility among buyers and sellers of US equity options saw its most dramatic decline in percentage terms on a weekly basis and its second biggest closing drop since the Japanese tsunami, earthquake, and nuclear meltdowns of March 16. The financial blog, Zerohedge, documents the event here while leaving the implications open to readers. Never mind that the effects of widespread nuclear radiation over an entire country are still unclear - the markets had already dismissed Japan as a non-factor going forward.

At this point, the technician in me feels the urge to add a few comments. I have pulled up my own daily chart of the Vix. Note the steep decline in the Stochastics which indicate a potentially oversold condition. Also noteworthy is the dramatic climb in the Standard Deviation. But pull back and examine the Vix on a longer horizon. While the Vix has experienced a dramatic fall, the charts indicate that there is further room for volatility to collapse.

My own thoughts are that volatility has collapsed too fast and too soon. Yet, I am also hedging my statements by indicating that there is further room to drop. On a historical basis using the benchmark of the past 4-5 years, the Vix has bottomed out at around the 15-16 level. Some readers may object that this time frame is relatively short. If so, they are welcome to expand their charts to as far back as 1995 (when the current Vix methodology was put in place).

But premiums on out of the money puts below the 15 level indicate that market participants don't really believe volatility can collapse much further. This is an implied floor. I think its safe to say that going long volatility (e.g. by buying future month calls) at those levels would be a relatively opportune bet on a risk/reward basis. Options premiums would have declined to sufficient levels to make such debit transactions relatively affordable. Note that this is pure speculation and not really a hedge. The options holder is still exposed to theta, or time decay. The Vix also signals a potentially overbought and oversold conditions among equity markets whenever it has advanced/declined by more than 25% on a weekly basis and more than 15-20% on a daily basis. Speculators can also play the reverse side by buying puts and/or selling calls once volatility has advanced by such levels.

But the S&P 500 Vix is not the only indicator of volatility. The CBOE (Chicago Board of Options Exchange) has been busy developing its proprietary Vix indicators for other volatile underlying assets such as (in no particular order) gold, oil, and now individual stocks. These instruments are all still relatively new and do not have the track record of the S&P 500 Vix so I do not readily follow them. Still I have mentioned them as an objective measure to be inclusive.

Another volatility indicator to follow is the 2 year swap spread (or 2YSS for short). The 2YSS measures the yield difference between 2 year interest rate swaps and 2 year Treasury notes. (Treasury notes are used as a benchmark for risk free rates b/c of the dollar's role as the only global reserve currency). The 2YSS is not as widely known among market followers as the Vix. However, it is a widely followed indicator among bond traders. Interested readers can obtain delayed data from Bloomberg's web site here here. Otherwise, real time streaming data requires access to a proprietary Bloomberg terminal.

Note that the 2YSS barely budged during the 2 week period of March 13-26. Thus, there was room for a fair bit of arbitrage trading between the equity, bond, and volatility markets. The last time it peaked was during late November/early December 2010 based on refinancing fears of the upcoming 2011 mortgage resets and fears of fiscal insolvency among US state and local governments as measured by municipal bond fund outflows. These fears were quickly quashed by additional Fed intervention and Congressional extension of additional tax cuts for another 2 years. Before this period, the 2YSS experienced its greatest volatility spike during the Greek budget Eurozone crisis of late May-June 2010 (which coincided interestingly enough w/the Flash Crash among US equities).

All this pondering on market volatility brings me to my final point. When will the Fed stop intervention? The short answer is: not anytime soon. But a more detailed explanation centers around speculation about the extension of Quantitative Easing 3.0 when the current operation is set to expire at the end of this June. Famed bond guru, Bill Gross, of PIMCO publicly stated that his fund had dumped its entire Treasury holdings in expectations of an end to Quantitative Easing.

Mr. Gross was not the only famed investor to publicly speculate on interest rate flows (readers more interested in Gross' thoughts can find out more here). Insurance companies and corporate CFOs are also rotating out of longer term US paper into shorter term maturities despite the paper losses they may take.

Sovereign holders of US debt such as Japan are believed to be in a position to temporarily stop or at least delay the purchase of additional US debt - especially in light of the massive amount of capital required to pay out insurance claims and reconstruction costs. A large part of the bill will be sponsored by the US and other wealthy nations but an already indebted Japan can ill afford to take on more debt. America's largest creditor, China, had already been on track to diversify its holdings of US debt. It is joined by oil exporters in the Middle East. The common unifying theme among these central banks? A push into gold and silver as reported by the Financial Times. Still, this should not be considered a carte blanche by China and Japan to eliminate US debt purchases. The basic public policies of both countries centers on ensuring cheap exports to maintain political and economic stability.
Eventually, the question will become not who is willing to buy US debt, but at what price and yield.

The Bottom Line: 1) Examine both the Vix and the 2YSS for arbitrage opportunities to go long or short among related risk assets and/or even volatility itself. 2) Quantitative easing is widely predicted to end by June 2011. Many market participants have already begin the process of rotating out of longer term US debt.
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