LAND HO!: “ESCAPE VELOCITY” ON THE HORIZON?

Takeaway: A continued breakdown of investors’ perception of tail risk bodes well for domestic capital markets and economic growth.

SUMMARY CONCLUSIONS:

 

  • With spot VIX itself having broke down to new post-crisis lows in recent weeks (and still bearish-TREND on our quantitative factoring), we are encouraged to see that the rolling premium for 6M-forward VIX is also breaking down hard from its recent post-crisis peak.
  • To the extent this trend does continue as we navigate the confluence of near-term domestic fiscal policy catalysts, we could be looking at a scenario six months from now where the ever-elusive “escape velocity” becomes a probable scenario to risk manage. 
  • By “escape velocity”, we are referring to a rather bullish environment where implied volatility across domestic capital markets trades sustainably lower (a la 2003-07) amid a commensurate pickup in economic activity and the velocity of money.
  • At any rate, hope remains no investment process and we definitely need to see more data to support this narrative.

 

Shortly after our morning call yesterday, a very astute client and equally-shrewd investor asked us: “Can you explain to me what the implication of the ‘term structure of the VIX’ coming down means versus the spot VIX index coming down?”

 

Simply put, investors paying up less for perceived tail risk is a bullish indicator for US equities, as it would indicate that investors are beginning the process of closing the book on the 2008-09 financial crisis once and for all – implying that they may be increasingly comfortable with taking on more risk.

 

To the extent these signals are being driven by requests from their clients or as a result of improved corporate sentiment, the recent breakdown in the term structure of the VIX curve may turn out to be a favorable signal for the domestic economy as a whole.

 

Technically speaking, “history” (i.e. we only have data going back to 2004) shows us that the premium investors are willing to pay for 6M-forward VIX relative to spot VIX should oscillate around +20%, with any major drawdowns in that premium typically being accompanied by a melt-up in spot prices. Looking at the data through the prism of a 3M moving average (to smooth out the inevitable S/T outliers), we’ve seen that premium widen to as high as a double (i.e. +40%) in the post-crisis era.

 

With spot VIX itself having broke down to new post-crisis lows in recent weeks (and still bearish-TREND on our quantitative factoring), we are encouraged to see that the rolling premium for 6M-forward VIX is also breaking down hard from its recent post-crisis peak.

 

LAND HO!: “ESCAPE VELOCITY” ON THE HORIZON? - 1

 

LAND HO!: “ESCAPE VELOCITY” ON THE HORIZON? - 2

 

LAND HO!: “ESCAPE VELOCITY” ON THE HORIZON? - 3

 

To the extent this trend does continue as we navigate the confluence of near-term domestic fiscal policy catalysts, we could be looking at a scenario six months from now where the ever-elusive “escape velocity” becomes a probable scenario to risk manage. By “escape velocity”, we are referring to a rather bullish environment where implied volatility across domestic capital markets trades sustainably lower (a la 2003-07) amid a commensurate pickup in economic activity and the velocity of money.

 

LAND HO!: “ESCAPE VELOCITY” ON THE HORIZON? - 4

 

At any rate, hope remains no investment process and we definitely need to see more data to support this narrative. Still, it’s always fun to dream…

                                                                                                                                                                                                                   

Happy Friday,

 

Darius Dale

Senior Analyst